Alternative Investment Funds in India Regulatory Framework Abhishek Parekh February 10, 2018 Shardul Amarchand Mangaldas & Co Mumbai
PRESENTATION STRUCTURE I) Introduction II) Typical structure of Alternative Investment Funds in India III) Life-cycle of an AIF IV) SEBI (Alternative Investment Funds) Regulations, 2012 Key Provisions V) Foreign Investment in AIFs VI) Recommendations of AIPAC Privileged & Confidential 2
INTRODUCTION
INTRODUCTION 1. The Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012 AIF Regulations were issued with effect from May 21, 2012 by the Securities and Exchange Board of India SEBI to regulate all types of private pools of capital in India. 2. The AIF Regulations replaced the Securities and Exchange Board of India (Venture Capital Funds) Regulations, 1996 VCF Regulations. - Under the VCF Regulations, a total of 208 venture capital funds had obtained registration from the SEBI over a period of 16 years. As of June 30, 2016, the total investments made by such VCFs amounts to approximately Rs. 335 Billion. 3. As of January 2018, there are 372 AIFs registered with the SEBI. - Total capital commitments raised by such AIFs amount to Rs. 1160.85 Billion and investments made by such AIFs amount to 434.89 Billion. Privileged & Confidential 4
CATEGORIES OF AIFS The AIF Regulations categorise funds into 3 categories, based on their investment focus and impact on the economy : AIF Categories Category I Category III Category II Those AIFs with positive spillover effects on the economy, for which certain incentives / concessions are given by the SEBI / Government. These include: - Venture Capital Funds (including Angel Funds) - SME Funds - Social Venture Funds - Infrastructure Funds Those AIFs which employ diverse or complex trading strategies and undertake leverage to a great extent. Residuary category - those AIFs which do not fall within Category I & III and do not undertake leverage or borrowing other than to meet operational requirements Privileged & Confidential 5
TYPICAL STRUCTURE - ALTERNATIVE INVESTMENT FUNDS IN INDIA
TYPICAL STRUCTURE Onshore Offshore Investor Asset Management Company / Investment Manager Investments in Funds for attractive return on investment Management of pool of funds for share in investment returns Investor AIF Investments in Funds for attractive return on investment Trusteeship services for a trusteeship fee Investor Trustee Company Co- Investment with the Fund Investor Investor Sponsor Investment in an SPV Investments in portfolio companies Offshore Fund Fund SPV Investments in portfolio of companies through an SPV Portfolio Co. 3 Portfolio Co. 4 Portfolio Co. 1 Portfolio Co. 2 Privileged & Confidential 7
PARTIES TO THE AIF 1. A Fund can take the form of (a) a trust under the Indian Trusts Act; (b) a company under the Companies Act; (c) a limited liability partnership; or (d) a body corporate Trust is preferred. 2. Typically, the parties involved are the Fund, the Sponsor, the Trustee, the AMC / Investment Manager. The documents executed are - An Indenture of Trust for the settlement of the Trust by the Settlor; - The Investment Management Agreement for delegation of authority to manage the fund and the payment of Management Fee to the AMC / Investment Manger; - The Private Placement Memorandum setting out the key terms of the AIF, investment focus and strategy and details of the fund management team. 3. Sponsor sets up the Fund required to have skin in the game. Ultimately responsible for the activities of the AIF. 4. Trustees could be a board of trustees or a trustee company independent professional trustees also permissible. Privileged & Confidential 8
LIFECYCLE, OPERATION AND MANAGEMENT OF AIFS
TYPICAL LIFE OF A CLOSE-ENDED AIF Certificate of Registration from SEBI Final Closing Life of the Fund (6-10 years from First Closing) Exit Period (4-5 years) Setting up the Fund (6-12 months) (12-18 months) (12-18 months) First Closing Extension in the life of the Fund (Upto 2 years) Investment Period (4-5 years) Privileged & Confidential 10
FUNDING BY INVESTORS 1. Upfront Contribution: - Paid at the time of execution of the contribution agreement. 2. Drawdown during the Investment Period: - To invest the money into identified portfolio companies; - Capital commitments to be drawndown in tranches; - Default on capital contribution could lead to (a) levy of interest by the AIF; or (b) cancellation or forfeiture of all or part of the units held by the defaulting Investor. 3. Drawdown after the Investment Period: - Only under limited / specified circumstances which are set out in the fund documents. Privileged & Confidential 11
COSTS Costs borne by the Fund 1. Set up Costs initial documentation, registrations, legal, taxation and advisory fee etc. 2. Marketing Fee fee paid to distributors? 3. Administration Costs meetings of the fund committees, the investors, reports, audit fees etc. 4. Management Fee paid to the AMC for providing investment advice to the AIF. 5. Investment & Transaction Costs - due diligence and documentation costs. Costs borne by the AMC 1. AMC employee costs. 2. Administration Costs all costs other than those costs that are specifically borne by the Fund. Privileged & Confidential 12
ECONOMIC RETURNS Returns (2 / 20 Model) 1. Management Fee a) During the Investment Period, management fee is paid as a percentage of the capital commitments. After the Investment Period, management fee is paid as a percentage of the cost of investments made by the AIF. b) Paid to offset the costs of running the Fund and the AMC Team. 2. Carried Interest / Performance Fee a) The AMC is paid a percentage of the profits made by the Fund, over and above the hurdle rate typically shared between the employees and the sponsors of the AMC. - Special class of units issued to persons entitled to earn carried interest. b) The entire carried interest is back-ended and paid after the initial capital is distributed to the investors also known as the waterfall mechanism. Privileged & Confidential 13
WATERFALL MECHANISM 1. Return of Capital First, 100% to Investors in proportion to their respective investment until the entire capital contributed by them is returned. 2. Hurdle Rate Second, 100% to all Investors in proportion to their respective investments until distributed amount is equal to X% of the invested amount. 3. Catch-up Third, 100% to the Investment Manager until the amount distributed equals 25% of the distribution made under point 2 above, i.e. the payments made towards the hurdle. 4. Carried Interest Fourth, of the balance amount, 80% to the Investors in proportion to their capital contribution and the balance 20% to the Investment Manager. Privileged & Confidential 14
DISTRIBUTION WATERFALL Particulars Case 1 Case 2 Case 3 Case 4 Assume that the amount invested by the Fund is Rs. 1,000 and the hurdle rate is 10% Particulars The Fund s investments do not perform as expected and it has Rs. 900 after disposition The Fund s investments perform moderately and it is Rs. 1,100 after disposition The Fund has Rs.1,125 after disposition The Fund does well and has Rs. 1,225 after disposition Capital Rs. 900 Rs. 1,000 Rs. 1,000 Rs. 1,000 Hurdle NA Rs. 100 Rs. 100 Rs. 100 Catch-up NA NA Rs. 25 Rs. 25 Carried Interest NA NA NA Rs. 20 (Rs 80 to the investor) Total Rs. 900 Rs. 1,100 Rs. 1,125 Rs. 1225 Privileged & Confidential 15
AIF REGULATIONS KEY PROVISIONS
AIF REGULATIONS KEY PROVISIONS Sr. No. Particulars Category I* Category II Category III 1. Investor requirements Any investor Indian, NR or NRI 2. Minimum Corpus Rs. 20 Crore 3. Minimum Subscription Rs. 1 Crore** 4. Minimum continuing interest of the sponsor or the manager 5. Maximum no. of investors for each scheme 6. Tenure Close ended Minimum 3 years 2.5% of the corpus or Rs. 5 Crore whichever is lower 5% of the corpus or Rs. 10 Crore whichever is lower One Thousand Optional - Open or Close ended 7. Maximum investment in a single investee company Note: Extension of tenure is permitted up to 2 years, subject to the approval of 2/3rds of the unit holders by value of their investment in the AIF. In the absence of the consent of the unit holders, the AIF shall fully liquidate within 1 year following expiration of the fund tenure or extended tenure. 25% of the investible funds 10% of the investible funds *Note: Separate terms and conditions apply for Category I VCF (Angel Funds). ** Note: Employees of the AMC are exempt from making this contribution. Privileged & Confidential 17
AIF REGULATIONS KEY PROVISIONS Sr. No. Particulars Category I Category II Category III 8. Investment in Associates* Requires approval of 75% of the investors 9. Other specific investment conditions Investment in venture capital undertakings, social ventures, SMEs or entities operating, developing or holding infrastructure projects** 10. Leverage Only for meeting temporary funding requirements for not more than 30 days, on not more than 4 occasions in a year and not more than 10% of the investible funds Primarily invest in unlisted investee companies or in units of other AIFs as specified in the placement memorandum Only for meeting temporary funding requirements for not more than 30 days, on not more than 4 occasions in a year and not more than 10% of the investible funds However Category II funds may engage in hedging subject to guidelines specified by the SEBI. Invest in securities of listed or unlisted investee companies or derivatives or complex or structured products. May engage in leverage or borrow, subject to consent from the investors in the fund and subject to a maximum limit, as may be specified by the SEBI. *Note: Associate means an entity in which a director, trustee, sponsor, manager of the AIF or a director or partner of the sponsor or manager, hold more than 15% of its equity share capital or partnership interest. **Note: Separate terms and conditions apply for each sub-category of Category I AIFs. Privileged & Confidential 18
AIF REGULATIONS KEY PROVISIONS Sr. No. Particulars Category I Category II Category III 11. Valuation Once every 6 months by an independent valuer appointed by the AIF Calculation of the net asset value should be independent of the fund management function of the AIF and such net asset value shall be disclosed to the investor at intervals of not longer than a quarter for close ended funds and not longer than a month for open ended funds. Privileged & Confidential 19
FOREIGN INVESTMENT IN AIFs
FOREIGN INVESTMENTS IN AIFs FDI in the Investment Manager 1. Prior to October, 2016 Foreign Direct Investment FDI in the financial services sector for fund based NBFCs was subject to the following minimum capitalization norms: USD 0.5 million for FDI upto 51% to be brought up front; USD 5 million for FDI more than 51% and up to 75% to be brought up front; and USD 50 million for FDI more than 75% of which USD 7.5 million to be brought up front and the balance in 24 months. Non-fund based NBFCs had a flat USD 0.5 million minimum capitalization requirement. 2. In October, 2016 these minimum capitalization norms were done away with. Now, 100% FDI is permitted under the automatic route, subject to the requirement of such financial service being regulated by a financial service regulator. FDI under the automatic route in a manager which is an LLP is unclear. Privileged & Confidential 21
FOREIGN INVESTMENTS IN AIFs FDI in an AIF 1. Prior to November, 2015 FDI in funds set up as trusts required government approval. 2. FDI is now permitted in AIFs under the automatic route (i.e. without the approval of the concerned ministry or the Reserve Bank of India). 3. Downstream investments by an AIF will be regarded as foreign investments if either the sponsor or the investment manager is not Indian owned and controlled. Downstream investment means indirect foreign investment, by an eligible Indian entity, into another Indian company / LLP, by way of subscription or acquisition. 4. The extent of foreign investment in the corpus is not a factor to determine whether the downstream investment by the AIF is to be considered a foreign investment. 5. A Category III AIF with foreign investment can make portfolio investment in only those securities or instruments in which a Registered Foreign Portfolio Investor is allowed to invest. Privileged & Confidential 22
TAXATION OF AIFs
TAXATION 1. Tax pass-through status for Category I and Category II AIFs (excluding income from business or profession). - AIFs to withhold tax on distribution/accrual of income (a) at the rate of 10% for resident investors; (b) as per rates in force (i.e. lower of tax treaty rates or domestic tax law) for non-resident investors. - No tax pass through for Category III AIFs. Tax paid at the fund level or determinate trust structure used for availing pass through benefits. 2. Business income taxable at the AIF level and correspondingly distribution of such income will be exempt in the hands of the investors. 3. Unutilised losses cannot be passed on to the investors - AIF to carry forward and set-off such losses in subsequent years. 4. Income received by the AIF from portfolio companies is exempt from withholding tax. 5. No dividend distribution tax is payable by Category I and Category II AIFs when distributing income to investors. Privileged & Confidential 24
RECOMMENDATIONS OF THE AIPAC
RECOMMENDATIONS OF THE AIPAC 1. The SEBI had constituted the Alternative Investment Policy Advisory Committee (AIPAC) under the chairmanship of Mr. Narayana Murthy in March 2015. - AIPAC was established to make recommendations on the reforms required for the development of the alternative investment eco-system in India. - Till date, the AIPAC has submitted 3 reports in December 2015 (1 st report), November 2016 (2 nd report) and November 2017 (3 rd report). 2. Major recommendations relate to : - Taxation of AIFs, including Category III AIFs (1 st, 2 nd & 3 rd report) - The GST regime relating to AIFs (3 rd report); - Unlocking domestic pools of capital (1 st & 2 nd report); - Promoting Onshore Fund Management (1 st report); - Enhanced disclosures and superior governance of AIFs (2 nd report); - Corporate Social Responsibility & Public Trust Recommendations (1 st & 3 rd report). Privileged & Confidential 26
THANK YOU Privileged 27 Privileged & Confidential 27 27